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Class Lecture Notes - Lecture #18 11/25/2003
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Class Lecture Notes - Lecture #18 11/25/2003


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  • 4/25/03 changed per Scott Dennis (IRR objectives changed)
  • Transcript

    • 1. Real Estate and Institutional Investment Strategies
      • Lecture Map
        • Institutional Portfolio Management
        • Role of Real Estate in an Investment Portfolio
        • Asset selection within the Real Estate Asset Class
          • What do institutions want from their real estate investments?
          • Is there a ‘best way’ to select real estate investments?
    • 2. Portfolio Management Theories
      • Efficient Frontier Theory
        • Optimize combination of assets along the “efficient frontier” to maximize returns relative to acceptable level of risk
        • Diversify portfolio to reduce correlation of returns, thereby reducing risk as much as possible given targeted return
      • Immunization Strategies
        • Select base portfolio to cover projected stream of liabilities
        • Balance of the portfolio invested to enhance returns
    • 3. The Efficient Frontier
      • In theory, investors should maximize returns at the margin for the amount of risk they are willing to bear
      • “ Risk” in this case is measured by the volatility of returns and the correlation - or lack thereof - of relative returns across asset classes
      • Assets are worth more in combination than individually if optimally combined based on the covariance of their returns
    • 4. Constructing an Efficient Portfolio
      • Choose the asset mix of your portfolio
        • Growth stocks
        • Value stocks
        • Fixed Income
        • Real Estate
          • Direct
          • Commingled Funds
          • REITs
      • Change the asset mix change over time
        • Market Timing
        • Style Rotation
        • Change in target risk and return
    • 5. Special Challenges for Real Estate with the Efficient Frontier Model
      • In practice, it is very difficult to measure real estate’s correlation with other assets
        • Historical data is not as robust as it is for stocks, bonds, making measurement difficult
        • Private real estate markets are also fragmented, inefficient, illiquid
          • Some properties correlate well with bonds – single credit net lease deals, multi-family
          • Others exhibit high volatility – hotels, suburban office
          • Performance can vary significantly between properties, markets
    • 6. Other Challenges of the Model
      • The efficient frontier ignores pension liabilities
        • Assets are selected based on what they contribute to the total return goals of the portfolio
        • Plan sponsors would also like to generate income that matches their liabilities
        • Liabilities are gaining focus today because of the losses of recent years
      • Benchmarking against target returns and indexes is also problematic for real estate
        • Most targets are annual
        • Most indexes are benchmarked quarterly
        • Real estate is a long term asset!
    • 7. Portfolio Immunization
      • Investment strategy based on meeting planned and/or projected liabilities versus a target rate of return
      • Methodology splits the portfolio into two pieces:
        • Core investments indexed to liability streams
          • Generates income to match size, timing of liabilities
          • Ties well with fixed income investments
        • Balance of the portfolio invested to enhance total return
          • Alternative assets, equities, etc.
      • Works best with fully and/or overfunded pension plans
        • Underfunded plans are by definition behind the total return curve in meeting even known liabilities
          • Lots of plans are underfunded today, however -> should they take more risk to meet obligations?
    • 8. Portfolio Immunization (cont.)
      • Immunization is getting lots of attention in the portfolio management world today:
        • “Post bubble” phenomenon
          • Institutional portfolios severely hurt by tech boom/bust
          • Portfolio discipline was missing in over-allocation to tech, private equity and venture capital
          • Concern over looming obligations to retiring baby boomers
    • 9. How Big was the Bubble?
    • 10. Other Attractions of Immunization
      • Stop the proliferation of ‘asset classes’
        • Immunization would classify assets by their role in the portfolio as opposed to role in diversification
          • “ what is the job” of each asset?
          • Inflation hedge; current income; long term growth
      • How efficient is asset allocation today anyway?
        • Look at real estate fundamentals vs. pricing
        • Are we creating another bubble of a different type?
    • 11. Why Real Estate Looks So Good in the Immunization World
      • Real estate combines return features of both bonds and stocks with low correlations to those asset classes
        • Current income and total return
        • Same argument used by the efficient frontier model, but for immunizers, the current income provides a hedge against liabilities; growth component offers “alpha”
      • Real estate also offers multiple investment strategies within the asset class to enhance total return
        • Opportunistic plays
        • Property type and sector plays
        • Market selection
    • 12. Role of Real Estate in An Investment Portfolio
      • Regardless of theory, widely agreed today that real estate should be a part of every investor’s portfolio
      • Real estate offers an ideal fit
        • Efficient Frontier -> low correlation
          • -> diversification
          • -> fixed income and appreciation attributes
        • Immunization -> fixed income attributes
              • -> return enhancement opportunities
      • Also generally agreed that investors are on average significantly underweighted in real estate
    • 13. Institutional Real Estate Strategies
      • Involves Selection of Investment Vehicles and Managers
      • Primary Investment Vehicles:
        • Private Equity Real Estate Funds
          • Core
          • Value-Add
          • Opportunistic
        • REITs
          • Market proxies
          • Regional, property type plays
        • Direct Deals
    • 14. Institutional Real Estate Strategies (cont.)
      • Implementation of any strategy is critically dependent upon manager selection
        • Expertise and track record
          • Deal experience
          • History of producing targeted returns
        • Transparency
          • How good, frequent, honest is the reporting?
        • Alignment of Interests
          • Incentive-based reward structure
    • 15. Institutional Real Estate Strategies (cont.)
      • Institutions invest disproportionately in private, direct deals today
        • Public REIT markets, universe of private equity funds too small to accommodate available capital
        • Selection of, relationship with manager is key
          • Real and/or perceived ability to influence operations and outcome of the investment
        • Facilitates periodic rebalancing if needed
          • Less liquidity than a REIT, but more than a fund with a greater degree of control over the asset, exit timing
    • 16. Real Estate Investment Strategies – Moving Beyond the Vehicle
      • Real Estate provides multiple opportunities to enhance returns at the margin in all investment vehicles
        • Stage and/or strategy selection
        • Property type allocation
        • Regional allocation
        • Market Selection
        • Property Selection
      • What are the selection issues?
        • Correlation between strategies
        • Long term economic and demographic shifts
    • 17. Return and Risk Attributes for Investment Stages and Strategies Core Re- capitalization Lease-up, Re-tenanting or Renovation Forward Commitment Development Core Re-capitalization Renovation Lease-up Forward Commitment on Development Development
      • Stable Market
      • Class A & B Properties
      • Prime Location
      • Objective: 8-10% IRR
          • 80% +
      • Leasing Risk
      • JV Structure
      • Retain Control
      • Objective: 10-12% IRR
      • Substantial Initial or Near-term Vacancy
      • Low Initial Yield
      • Objective: 11-13% IRR
      • Major Capital Expenditures
      • Increase Revenues
      • Objective: 11-13% IRR
      • Minimal Construction Risk
      • Minimal Zoning/ Entitlement Risk
      • Fund at Completion
      • Leasing Risk
      • JV or Wholly-Owned
      • Objective: 12-14% IRR
      • Limited Construction Risk
      • Leasing Risk
      • Minimal Zoning and Entitlement Risk
      • Objective: 13-18% IRR
      Development Entity Investing Entity Investing
      • Operating Partner Risk
      • Reduced Level of Control
      • 40-90% Leverage
      • Objective: 18% + IRR
      Risk Attributes Value-Added Strategies
    • 18. Property Type Allocation
      • Office and Industrial properties are most cyclical, most closely reflect economic cycles
        • Office -> either the best or the worst performer. A lagging indicator. Time the cycles, underweight suburban “commodity” deals in general
        • Industrial -> generally outperforms office, more stable returns than office. More of a leading indicator.
      • Retail and Multifamily are considered more stable
        • Retail -> negative correlation with office, good absolute returns. Reflects consumer-driven economy
        • Multifamily -> considered defensive, counter-cyclical. Influenced by demographic trends as well as job growth
    • 19. Regional Allocation
      • Property type selection within regions is important
        • Gets back to economic base analysis!
        • What industries, activities drive the local economy and will be reflected in real estate needs?
      • East and West
        • Higher returns, higher risk
        • More heavily concentrated in office product because of the financial focus of coastal economies
      • Midwest
        • Correlated with the East coast, although more heavily industrial in nature
      • South
        • Low correlations with West, higher risk adjusted returns on average than either coast
        • Long term demographic shifts favor the south
    • 20. Market Selection
      • Drivers of Market Selection:
        • Employment growth and comparative economic strength
        • Ease of adding new supply
        • Historical absorption track record
        • Property preferences -> which do better in given market?
      • International vs. National Markets:
        • Direct comparisons are difficult to make
          • U.S. market is a “traded” market; foreign markets are not
          • Long term holds might favor stability of yield in W. Europe
        • Does the recommended diversification model apply here?
        • Prologis strategy: provide U.S.-style service to customers in foreign markets
        • Goldman approach: move opportunistically in and out of international markets
    • 21. Property Selection
      • Pick your size
        • Smaller assets have historically outperformed larger assets
          • Wider audience offers greater liquidity
          • If your holding period is short, evaluated exit opportunity
      • Pick within asset classes
        • Suburban vs. CBD office
          • CBD considered more stable
        • Regional mall vs. power center vs. neighborhood center
          • Neighborhood center in favor
        • Flex R&D vs. distribution
          • Flex R&D is more cyclical
        • Garden-style multifamily vs. high rise, urban condominium
          • Garden-style considered more generic and defensive
        • Full service, limited service, resort hotels
          • Luxury full service most defensive, resort most cyclical